Paradigm shift in asset management Part 2: Diversification - models and limits

The need for diversification of risk across different individual investments is unquestionable. Achieving sensible and appropriate diversification is accordingly a basic subject area in asset management. However, after the exceptional events of 2008, a whole range of assumptions previously regarded as standard now have to be reconsidered.

Let us assume that out of the whole universe of all possible financial investments we could pick the one which is expected to make the most profit. Wouldn’t every rational investor put all their money into just that one asset? The answer is yes – but only if they could be certain of actually making this profit in future. Because this is obviously not the case, investors have from time immemorial been inclined – purely intuitively – to spread their capital across different investments. This principle – what we now call diversification – has been handed down in sayings over the generations, and finally put on a sound theoretical footing in the 20th century. However, implementation is still a practical and theoretical problem.
Academically, the topic of diversification has been around for more than half a century. In his 1952 paper “Portfolio Selection”, Harry Markowitz proved for the first time that a properly diversified portfolio of assets with positive expected returns has a lower risk than each individual investment. This is the basis and starting point for modern portfolio theory with its statistical underpinnings, and the concepts have ruled the field in asset management until the present.
But how is this diversification achieved?

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